Increasing signs of state and crony capitalism

Instead of promoting investments in construction sectors the government should advance quality investments in the environment, energy, and workers’ skills

The political and business elite of Cyprus are stifling equitable growth

By Les Manison

In an article in the Sunday Mail of January 14, 2018, I argued that the Cyprus economic system exhibited many of the hallmarks of crony capitalism. That is, there was a nexus between the business class and the ruling political class in Cyprus that impedes and distorts the optimum allocation of economic resources through the free market. Indeed, it was contended that the economic system of Cyprus was one in which family members and friends of government officials as well as business leaders are given unfair advantages in the form of public and PPP (Public Private Partnership) contracts, consultancy assignments, jobs, loans, debt relief and so on.

Recent developments such as the government-engineered arrangements for Hellenic Bank to take over the good part of the Central Co-operative Bank and leaving the bad part to the government, indicate that gains are passed over to special interest groups in the private sector while losses are being socialised at the expense of the law-abiding taxpayer.

And other developments like the Estia debt relief scheme reveal that the Cyprus economy is becoming increasingly inflicted with a brand of state capitalism. Namely, the government is undermining market laws and mitigating business entities’ assumption of risk by funding private sector units with its own borrowed funds, and through this process allowing private interests to reap the profits, but having the tax payer shoulder the losses.

In consequence the comfortable co-existence of crony capitalism and state capitalism has led to the increasing corruption of what was a free market-based capitalist system in Cyprus. Indeed, many of the fundamentals on which the efficient functioning of the capitalist system for the benefit of Cyprus society rest are being increasingly undermined. And by abusing these fundamentals, most notably in the lax and selective application of the rule of law and regulations and in moving markets away from genuine competition, the “political and business elite” of Cyprus are damaging substantially the real economy and also the environment.

Selective application of laws

Inefficiencies and deficiencies in the justice system and in the public sector, particularly tax administration, are gladly tolerated and exploited by the ruling class to selectively apply or bypass laws and regulations so as to favour particular business entities and politically connected individuals. Most notably, antiquated legal procedures and lengthy politically tainted court proceedings and judgements contribute to weak contract enforcement including those for title deeds. Genuine competition is crushed, high-quality foreign productive investment is discouraged and income and wealth inequalities are exacerbated.

In particular, certain leading property developers and hoteliers are not only extended loans on lenient terms, but are allowed to effectively violate loan contracts through generous debt write-offs, often involving the exchange of over-valued property, and in the rescheduling of their loan repayments. These developers are also permitted to break environmental regulations such as in the construction of buildings in nature-protected areas.

Inefficient, biased tax collection

The grossly distorted application of an inefficient tax system in Cyprus contributes importantly to an unlevel playing field and deprives the government of funds required to provide high quality public services and infrastructure. Corporations and self-employed persons which are not subject to withholding taxes on their incomes engage in much tax evasion and avoidance that is tolerated by the government. And with generous tax amnesties, great delays in assessments of tax returns (five to six years for this author) and small actual penalties, tax evasion is even implicitly encouraged. It is noteworthy that income tax collections from the self-employed have fallen dramatically in recent years declining from 82 million euros in 2012 to an estimated 34 million euros in 2018 whereas income tax collections from government employees rose from 46 million euros in 2012 to an estimated 70 million euros in 2018.

For most Cyprus households, business entities and non-profit organisations such as the Greek Orthodox Church their main component of wealth is immovable property. And with a tax system that minimises the taxation of property and levies no taxes on gifts and inheritances, those entities with the greatest wealth such as the established rich families of Cyprus have been able to accumulate more wealth and resources relative to poorer households. Furthermore, these wealthy entities have been able to use their economic power to influence political decisions such as in abolishing the central government tax on immovable properties in 2017.

Favours to property sector

The pursuit of state and crony capitalism in recent years is most strikingly reflected in the implementation of the so-called Golden Visa scheme. Under this scheme foreign citizens can acquire Cyprus citizenship and essentially an EU passport if they invest a minimum of 2.5 million euros in immovable property and/or government bonds. This scheme with its lax criteria for eligibility including no requirement of residency and no scrutiny of where proceeds for purchasing Cyprus property come from has been highly successful in supporting the strong rebound of construction activity and property prices and rents, especially in Limassol. However, the most prominent beneficiaries of the scheme, which has yielded around 6 billion euros in proceeds, have been the lawyers, accountancy firms and real estate agents that process and handle the applications from non-EU citizens, many of the former being relatives, friends and business cronies of top government officials and politicians.

In addition, generous tax incentives are provided for transactions and investments in real estate including VAT exemptions for rental of property for residential purposes and on disposal of immovable property for which the building permit was submitted prior to May 1, 2004.

The labour market

Cyprus has a large pool of well-educated and skilled persons in its labour market. However, with the prevailing crony capitalism, obtaining permanent employment is mainly determined by who you know rather than what you know. This means that many persons fail to find jobs to fully utilise their talents and earn decent salaries, thus robbing Cyprus of their full potential to contribute to economic growth. Furthermore, with key institutions like government ministries and agencies and the Central Bank not productively employing the best talent available, these institutions are weakened and often fail to competently handle their key responsibilities. In this respect the finance ministry, the Central Bank and legal authorities have performed miserably in dealing with problems associated with the extremely high indebtedness of the Cyprus private sector.

Lack of equitable growth

As a result of the pursuit of Cyprus brands of state and crony capitalism, inequalities in employment opportunities and in income and wealth distributions have been perpetuated. While the growth of real GDP and employment has been relatively strong since 2014, the benefits of the growth dividend have not been widely shared and have just accrued mainly to leading professionals and business entities. It is quite striking that compensation of employees as a proportion of nominal GDP declined from over 48 per cent in 2012 to under 44 per cent in 2017 and probably fell more in 2018 as profits in the tourist and real estate sectors surged.

The European Commission’s latest country report states that Cyprus (along with Greece and Italy) continue to have severe macroeconomic imbalances in several areas, namely in high stocks of private, public and external debt and of non-performing loans. And even if you questionably exclude the debt of Special Purpose Entities, private bank debt amounted to nearly 44 billion euros or 214 per cent of GDP at the end of September 2018. Bankers with their participation in crony capitalism have extended loans incompetently and irresponsibly to privileged clientele and, in many cases, have not seriously sought repayments. And the central government with its generous funding and guaranteeing of private banks, semi-government organisations and municipalities is increasingly exercising a brand of state capitalism that is being revealed in the continuous accumulation of public debt,that now amounts to around 110 per cent of GDP.

Remedies

Diminishing crony and state capitalism in Cyprus and their detrimental effects on the economy including on resource allocation and debt accumulation will require a fundamental change in the political willingness to evenly and rigorously enforce laws and regulations. And to be effective in efforts to counter tax evasion and debt defaulting, institutional capacity, especially in the legal and justice systems and in tax administration, will need to be substantially enhanced.

Instead of promoting investments in the real estate and construction sectors the government should promptly phase out the investment for citizenship scheme with its negative externalities and focus on advancing quality investments in the environment, energy, digitalisation, workers’ skills and innovation using to a much greater extent available EU funding. This reallocation and diversification of resources based on appropriate risk assessments by government bodies and banks would raise productivity and provide better, more permanent employment opportunities for the educated youth, and in the process boost equitable and sustainable growth.

Leslie G Manison is an economist and financial analyst, specialising in macroeconomic policy analysis, bank viability assessments and international financial relations. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus

Information

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